Investment Allocation and Performance in Venture Capital Scott Hsu - - PowerPoint PPT Presentation

Investment Allocation and Performance in Venture Capital

Scott Hsu Vikram Nanda Qinghai Wang

U of Arkansas U of Texas Dallas U of Central Florida

The Unique Structure of VC Funds

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VC (PE) funds have a typical 10-year life span – VC firms need to keep raising new funds.

Kleiner, Perkins, Caufield & Byers

Fund Vintage Year Committed capital ($M) NET IRR II 1980 65 50.6% III 1982 150 10.2% IV 1986 150 11.0% V 1989 150 35.7% VI 1992 173 39.2% VII 1994 225 121.7% VIII 1996 299 286.6% IX 1999 550

• 23.3%

X 2000 625

• 17.5%

XI 2004 400 XII 2006 600 XIII 2008 700 XIV 2010 625 XV 2012 525 XVI 2014 450 XVII 2016 400

The Unique Structure of VC Funds (Cont.)

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VCs start the next fund while the current fund is still active.

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Our research question: If there is a “next Google” in between two funds, would the VC place it to the current fund or the next one? §

Why?

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Implications for VC fund structure & performance (persistence)?

Does VC fund structure (or fundraising motive) affect investment decisions?

§ Our story: Can affect VC investment and/or

investment allocation decisions.

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Within a VC fund.

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Across VC funds when two funds overlap in time.

§ Such decisions can then affect VC fund

performance, and performance persistence.

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Such behavior has implications for VC-Investor relation, as well as the VC-entrepreneur relation.

How does the VC fund structure (or the fundraising motive) affect investment decisions?

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We have a stylized model.

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Find existence of an equilibrium in which raising capital for the next fund is affected by the early success of current fund.

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In such an equilibrium, VCs allocate higher quality projects in the early investment period.

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Intuition – VC’s have limited time/ability and choose where to put in most effort. Gives rise to a coordination equilibrium in which VCs allocate effort to projects in the new (or young) fund – and learning about their ability primarily occurs depending on success or failure in new fund. §

Possibility if multiplicity of equilibria – but less likely because the VC benefits from better contract in the new fund that is where he is expected to devote his energies.

Predictions from the model

§ Higher probability of success in early investments. § For two sequential funds, during concurrent investment period, better quality projects are allocated to the new fund instead of the current fund. § Performance of early investments is more informative across VC funds of the same VC firm.

Data and Sample

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Information on VC firms, VC funds, and VC investments: Venture Xpert.

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Focus on VC fund investments by lead VCs. §

VCs that make investment (allocation) decisions.

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2,617 firms, 4,578 funds, and 17,154 companies from 1975 to 2010.

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Measuring investment outcomes using successful exit: IPOs and IPOs/M&As. §

Used and accepted in academic research.

VC Portfolio Company Exits (univariate) – as Lead VC

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Within fund performance: early investments in a fund perform better (Table 3)

(1) (2) (3)

• Dep. Var: =1 if IPO

=1 if the First Investment 0.2291*** (2.653) Investment Sequence No.

• 0.6262***

(-5.082) =1 if First-year Investment 0.2512*** (3.221) (4) (5) (6)

• Dep. Var: =1 if IPO or M&A

=1 if the First Investment 0.2358*** (4.113) Investment Sequence No.

• 0.5826***

(-7.211) =1 if First-year Investment 0.2763*** (4.960)

Controls: Fund sequence, fund size, seed/early stage, No. of IPOs, Ind. M/B ratio, bubble period dummy, VC firm fixed effects.

Why do early investments in a fund perform better?

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(Natural) Decline in the quality of the projects available within the fund.

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Could be partly driven by the investment allocation across the funds

• f the same VC, as suggested by the model.

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How to test the investment allocation story?

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Use the “paired” VC fund sample – two funds with overlapping investment period.

The “paired” VC fund sample – some definitions

— Concurrent investment period: One-year period after

the start of the second fund’s first investment.

— First fund: early investments (pre-concurrent period);

later investments (concurrent period)

— Second fund: early investments (concurrent period);

later investments (post-concurrent period)

Exit rate of the “paired funds” (Table 4)

First Fund Prior to Concurrent Period First Fund during Concurrent Period Second Fund during Concurrent Period IPO Rate 10.11% 3.51% 9.11% IPO and M&A Rate 31.48% 13.71%

• 36. 06%

Investment outcome of the paired funds during concurrent period (Table 5)

• Dep. Var.

IPO IPO+M&As Ln(Financing rounds) (2) (4) (6) =1 if Investment from Second Fund 0.230* 0.315*** 0.150*** (1.88) (4.35) (5.00)

— Logit & Linear Probability Models (above are OLS results) — Controls: VC FE, Fund sequence, size, size-squared, early

stage/seed fund, no. of IPOs in prior to fund’s vintage year, industry M/B, seed/early-stage company, dummy for for 1995- 2000.

— The results are more pronounced if (1) the first fund has successful

early investments, and (2) the lead VC is more reputable (Table 6).

Performance persistence (fund-level; Table 7) §

Use IPO or IPO/M&A dummy as performance predictor.

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Performance persistence across two funds (Models 1 and 2).

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No performance persistence within the (first) fund (Models 3 and 4).

Second Fund (Total Investments) First Fund Later Investments IPO IPO/M&A IPO IPO/M&A IPO in First Fund Investments 0.479*** (3.33) IPO/MA in First Fund Investments 0.331*** (2.65) IPO in First Fund Early Investments 0.066 (0.24) IPO/M&A in First Fund Early Investments

• 0.247

(-1.53)

Performance persistence (fund-level; Table 8)

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First fund early investment success predict second fund early investment success (Models 1 and 2).

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First fund early investment success predict second fund overall investment success (Models 3 to 6).

(1) (2) (3) (4) (5) (6) Second Fund Early Investments Second Fund Overall Investments

• Dep. Var.

IPO IPO/MA IPO IPO/MA IPO IPO/MA IPO First Fund Early Inv. 0.433*** 0.515*** 0.514*** (2.81) (3.45) (3.45) IPO/MA First Fund Early Inv. 0.248** 0.260** 0.259** (2.1) (2.17) (2.16) IPO First Fund Late Inv. 0.062 (0.15) IPO/MA Fist Fund Late Inv. 0.324 (1.26)

Investment Outcome and Fundraising (Table 9)

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Early investment success leads to more fundraising.

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The results are insignificant for more experienced VCs.

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Provides motives for investment allocation across VC funds.

(1) (2) (3) (4) (5) (6)

• Dep. Var:

Probability of raising next fund within the first 5 years All VCs High Experience VCs Low Experience VCs =1 if first investment success

0.371*** 0.271 0.515*** (2.75) (1.37) (2.73)

=1 if first year investment success

0.488*** 0.126 0.685*** (3.16) (0.53) (3.16)

Conclusion

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VC fund structure (or the fund raising incentive) affects VC investment/ investment allocation decisions.

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We provide a stylized model for the rationales.

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We find evidence of investment allocation.

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Investment allocation has impacts on observed investment outcome and VC fund performance persistence.